CHAPTER 22
BOND PORTFOLIO
MANAGEMENT STRATEGIES
CHAPTER SUMMARY
In this chapter we look at bond portfolio strategies where the benchmark by which a manager is
evaluated is a bond index. Before we discuss bond portfolio management strategies in this
chapter, we begin with a discussion of the asset allocation decision in two contexts: allocation of
THE ASSET ALLOCATION DECISION
Public pension funds have allocations of about 2/3 in equities (which includes real estate and
private equity) and about 1/3 in fixed income. Regardless of the institutional investor, there are
How Much Should Be Allocated To Bonds?
The decision as to how much to invest in the major asset classes is referred to as the asset
allocation decision. The asset allocation decision must be made in light of the investor’s
investment objective.
Who Should Manage the Bond Portfolio?
Let’s assume that an investor has made the decision to allocate a specified amount to the fixed
income sector. The next decision that must be made is whether that amount will be managed by
internal managers or external managers or by a combination of internal and external managers. If
external managers are hired, a decision must be made as to which asset management firm to
engage.
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In practice, the term asset allocation is used in two contexts. The first involves allocation of
funds among major asset classes that includes bonds, equities and alternative assets. The second
way is how the funds should be allocated amongst the different sectors within that asset class
after a decision has been made to invest in a specified asset class. In the case of equities, equities
are classified by market capitalization and by other attributes such as growth stocks value. The
asset allocation among the different sectors of the bond is made at two levels. The first is where
a client must make a decision as to allocate among each sector and then if an external money
manager is to be hired, deciding on the asset management and amount to be allocated to each.
PORTFOLIO MANAGEMENT TEAM
We refer to the person making the investment decisions as the “manager” or “portfolio manager.”
The composition and therefore risk exposure of a portfolio is the result of recommendations and
research provided by the portfolio management team.
At the top of the investment organization chart of the investment group is the chief investment
officer (CIO) who is responsible for all of the portfolios. A chief compliance officer (CCO)
SPECTRUM OF BOND PORTFOLIO STRATEGIES
The bond portfolio strategy selected by an investor or client depends on the investment
objectives and policy guidelines. In general, bond portfolio strategies can be categorized into the
following three groups: (1) bond benchmark-based strategies, (2) absolute return strategies, and
(3) liability-driven strategies.
Bond Benchmark-Based Strategies
There is a wide range of bond portfolio management strategies for an investor or client who has
selected a bond index as a benchmark. Traditional bond benchmark-based strategies can be
from low risk strategies at the top to high risk-tolerance strategies at the bottom of the above list.
It is not only important to understand what the risk factors are, but also how to quantify them.
Absolute Return Strategies
In an absolute return strategy, the portfolio manager seeks to earn a positive return over some
time frame irrespective of market conditions. Few restrictions are placed on the exposure to the
Liability-Driven Strategies
A bond portfolio strategy that calls for structuring a portfolio to satisfy future liabilities is called
a liability-driven strategy. When the portfolio is constructed so as to generate sufficient funds
to satisfy a single future liability regardless of the course of future interest rates, a strategy
BOND INDEXES
Typically, bond portfolio managers are given a mandate that involves their performance
evaluation relative to a bond index. The wide range of bond market indexes available can be
classified as broad-based market indexes and specialized market indexes. Why have
Understanding the eligibility requirements for inclusion in a bond index is important. Active
bond portfolio strategies often attempt to outperform an index by buying non-eligible or
non-index securities.
THE PRIMARY RISK FACTORS
Primary risk factors in bond indexes are those risk factors that a portfolio manager can match or
mismatch when constructing a portfolio. A portfolio manager will only intentionally mismatch if
the belief is that the manager has information that strongly suggests there is a benefit that is
expected to result from mismatching.
The primary risk factors can be divided into two general types: systematic risk factors and
non-systematic risk factors. Systematic risk factors are forces that affect all securities in
TOP–DOWN VERSUS BOTTOM–UP PORTFOLIO CONSTRUCTION AND MANAGEMENT
There are two general approaches to construction and management of a bond portfolio: top-down
and bottom-up. Typically, a portfolio blends the elements of both approaches in junction with
certain considerations and constraints in constructing a portfolio.
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The bottom-up approach to active bond portfolio management focuses on the micro analysis of
individual bond issues, sectors, and industries. The primary research tools used in this form of
investing is credit analysis, industry analysis, and relative value analysis. To control the
portfolio’s risk, risk modeling is used.
ACTIVE PORTFOLIO STRATEGIES
Armed with an understanding of the primary risk factors for a benchmark we now discuss
various active portfolio strategies that are typically employed by managers.
Manager Expectations Versus the Market Consensus
Interest-Rate Expectations Strategies
A money manager who believes that he or she can accurately forecast the future level of interest
rates will alter the portfolio’s sensitivity to interest-rate changes.
A portfolio’s duration may be altered by swapping (or exchanging) bonds in the portfolio for
new bonds that will achieve the target portfolio duration. Such swaps are commonly referred to
as rate anticipation swaps.
Yield Curve Strategies
The yield curve for U.S. Treasury securities shows the relationship between their maturities and
yields. The shape of this yield curve changes over time. Yield curve strategies involve
positioning a portfolio to capitalize on expected changes in the shape of the Treasury yield curve.
Types of Shifts in the Yield Curve and Impact on Historical Returns
A shift in the yield curve refers to the relative change in the yield for each Treasury maturity.
A parallel shift in the yield curve is a shift in which the change in the yield on all maturities is
the same. A nonparallel shift in the yield curve indicates that the yield for maturities does not
change by the same number of basis points.
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Historically, two types of nonparallel yield curve shifts have been observed: a twist in the slope
of the yield curve and a change in the humpedness of the yield curve. A flattening of the yield
curve indicates that the yield spread between the yield on a long-term and a short-term Treasury
has decreased; a steepening of the yield curve indicates that the yield spread between
a long-term and a short-term Treasury has increased. The other type of nonparallel shift,
a change in the humpedness of the yield curve, is referred to as a butterfly shift.
Yield Curve Strategies
In portfolio strategies that seek to capitalize on expectations based on short-term movements in
yields, the dominant source of return is the impact on the price of the securities in the portfolio.
This means that the maturity of the securities in the portfolio will have an important impact on
Duration and Yield Curve Shifts
Duration is a measure of the sensitivity of the price of a bond or the value of a bond portfolio to
changes in market yields. A bond with a duration of 4 means that if market yields change by 100
basis points, the bond will change by approximately 4%. However, if a three-bond portfolio has
Analyzing Expected Yield Curve Strategies
The proper way to analyze any portfolio strategy is to look at its potential total return. If
a manager wants to assess the outcome of a portfolio for any assumed shift in the Treasury yield
curve, this should be done by calculating the potential total return if that shift actually occurs.
Duration is just a first approximation of the change in price resulting from a change in interest
rates. Convexity provides a second approximation. Dollar convexity has a meaning similar to
convexity, in that it provides a second approximation to the dollar price change. For two
that of the barbell portfolio, and (3) the dollar convexity of the barbell portfolio is greater than
that of the bullet portfolio. Which portfolio should he choose? Actually, the portfolio manager
does not have enough information to make an adequate decision. What is necessary is to assess
the potential total return when the yield curve shifts.
Which portfolio is the better investment alternative if the yield curve shifts in a parallel fashion
and the investment horizon is six months? The answer depends on the amount by which yields
Approximating the Exposure of a Portfolio’s Yield Curve Risk
A portfolio and a benchmark have key rate durations. The extent to which the profile of the key
rate durations of a portfolio differs from that of its benchmark helps identify the difference in
yield curve risk exposure.
Complex Strategies
Yield Spread Strategies
Yield spread strategies involve positioning a portfolio to capitalize on expected changes in yield
spreads between sectors of the bond market. Swapping (or exchanging) one bond for another
Credit Spreads
Credit or quality spreads change because of expected changes in economic prospects. Credit
spreads between Treasury and non-Treasury issues widen in a declining or contracting economy
Spreads between Callable and Noncallable Securities
Spreads attributable to differences in callable and noncallable bonds and differences in coupons
Importance of Dollar Duration Weighting of Yield Spread Strategies
What is critical in assessing yield spread strategies is to compare positions that have the same
dollar duration. To understand why, consider two bonds, X and Y that are being considered as
Individual Security Selection Strategies
There are several active strategies that money managers pursue to identify mispriced securities.
The most common strategy identifies an issue as undervalued because either (i) its yield is higher
than that of comparably rated issues, or (ii) its yield is expected to decline (and price therefore
Strategies for Asset Allocation within Bond Sectors
The ability to outperform a benchmark index will depend on the how the manager allocates
funds within a bond sector relative to the composition of the benchmark index. The incremental
THE USE OF LEVERAGE
If permitted by investment guidelines a manager may use leverage in an attempt to enhance
portfolio returns. A portfolio manager can create leverage by borrowing funds in order to acquire
a position in the market that is greater than if only cash were invested. The funds available to
Motivation for Leverage
The basic principle in using leverage is that a manager wants to earn a return on the borrowed
funds that is greater than the cost of the borrowed funds. The return from borrowing funds is
produced from a higher income and/or greater price appreciation relative to a scenario in which
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no funds are borrowed.
The return from investing the funds comes from two sources. The first is the interest income and
the second is the change in the value of the security (or securities) at the end of the borrowing
period
There are some managers who use leverage in the hopes of benefiting primarily from price
changes. Small price changes will be magnified by using leveraging. For example, if a manager
expects interest rates to fall, the manager can borrow funds to increase price exposure to the
market. Effectively, the manager is increasing the duration of the portfolio.
Thus the risk associated with borrowing funds is that the security (or securities) in which the
borrowed funds are invested may earn less than the cost of the borrowed funds due to failure to
generate interest income plus capital appreciation as expected when the funds were borrowed.
Leveraging is a necessity for depository institutions (such as banks and savings and loan
associations) because the spread over the cost of borrowed funds is typically small. The
magnitude of the borrowing (i.e., the degree of leverage) is what produces an acceptable return
for the institution.
Duration of a Leveraged Portfolio
In general, the procedure for calculating the duration of a portfolio that uses leverage is as
follows:
Step 1: Calculate the duration of the levered portfolio.
Step 2: Determine the dollar duration of the portfolio of the levered portfolio for a change in
interest rates.
rate change used in Step 2 in bps
How to Create Leverage Via the Repo Market
A manager can create leverage in one of two ways. One way is through the use of derivative
instruments. The second way is to borrow funds via a collateralized loan arrangement.
Repurchase Agreement
There is a good deal of Wall Street jargon describing repo transactions. To understand it,
remember that one party is lending money and accepting a security as collateral for the loan; the
other party is borrowing money and providing collateral to borrow the money.
Credit Risks
Despite the fact that there may be high-quality collateral underlying a repo transaction, both
parties to the transaction are exposed to credit risk.
Determinants of the Repo Rate
There is not one repo rate. The rate varies from transaction to transaction depending on a variety
of factors: quality of collateral, term of the repo, delivery requirement, availability of collateral,
and the prevailing federal funds rate.
KEY POINTS
• The asset allocation decision is the decision made to determine how much should be allocated
amongst the major asset classes and is made in the light of the investment objective.
• Once the asset allocation decision is made, the client must decide whether to use only internal
managers, use only external managers, or use a combination of internal and external
managers.
• With a core/satellite strategy there is a blending of an indexed strategy (to create a low-risk
core portfolio) and an active strategy (to create a specialized higher risk-tolerant satellite
portfolio).
• The wide range of bond market indexes available can be classified as broad-based market
indexes and specialized market indexes.
• The primary risk factors affecting a portfolio are divided into systematic risk factors and
nonsystematic risk factors. In turn, each of these risk factors is further decomposed.
Systematic risk factors are divided into term structure risk factors and non-term structure risk
factors. Examples of non-term structure risk factors are sector risk, credit risk, and optionality
risk. Non-systematic risk factors are classified as issuer-specific risk and issue-specific risk.
ANSWERS TO QUESTIONS FOR CHAPTER 22
(Questions are in bold print followed by answers.)
1. Why might the investment objective of a portfolio manager of a life insurance company
be different from that of a mutual fund manager?
The first step in the investment management process is setting investment objectives. The
investment objective will vary by type of financial institution. The objectives of a life insurance
company and a mutual fund company are different with a life insurance company generally
focusing more on safer fixed income investments that are needed to match its liabilities. More
details are given below.
2. Indicate whether you agree or disagree with the following statement: “A portfolio
manager who outperforms a benchmark implies that he meets the investment objective of a
client.
One would disagree with the above statement.
An index or benchmark may produce low or even negative returns over a period of time. Thus,
even if a manager outperforms the benchmark, the objectives of a particular fund (such as
meeting required liabilities) may not be met. As discussed below, there are ways managers can
overcome this problem.
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achieve investment objectives. Within the context of these strategies, an active or enhanced
return strategy may be followed.
3. The following two quotes are from the website for the FTIF Franklin High Yield Fund
dated December 31, 2009(http://www.franklintempleton.com.es/pdf/funds/fdata/0825_ksp_es.pdf):
a. “Portfolio risk is controlled primarily through our extensive bottom-up, fundamental analysis
process, as well as through security and industry diversification.” What does this mean?
The statement refers to how FTIF Franklin High Yield Fund seeks to contain portfolio risk,
which is to say how it seeks to lower the probability that individual investments in its portfolio
will fall in value. It has chosen a bottom-up approach that involves a basic process using various
forms of diversification to control market or systematic risk. More details are given below.
There are two general approaches to construction and management of a bond portfolio to over
risk factors: top-down and bottom-up. Typically, portfolio managers do not use a pure top-down
or bottom-up approach but instead blend the elements of both in junction with certain
considerations and constraints in constructing a portfolio. FTIF Franklin High Yield Fund uses
b. “The overall volatility of the product (i.e., standard deviation) and tracking error versus its
benchmark and peer group is monitored and projected from a top-down quantitative approach.”
What is meant by a top down approach? (In the next chapter, the quantitative approach
and tracking error will be discussed.)
There are two general approaches to construction and management of a bond portfolio to over
risk factors: top-down and bottom-up. Typically, portfolio managers do not use a pure top-down
or bottom-up approach but instead blend the elements of both in junction with certain
considerations and constraints in constructing a portfolio. In general, atop-down approach (also
In the top-down approach, a bond portfolio manager looks at the major macro drivers of bond
returns (hence this approach is also referred to as a macro approach) and obtains a view
(forecast) about these drivers in the form of a macroeconomic forecast. Among the major
variables considered in obtaining a macroeconomic forecast are monetary policy, fiscal policy,
tax policy, political developments, regulatory matters, exchange-rate movements, trade policy,
demographic trends, and credit market conditions. For a portfolio manager who is managing
a global bond portfolio, a macro forecast is required for all country markets. Based on this
4. Answer the below questions.
a. What is the essential ingredient in all active portfolio strategies?
Selecting a portfolio strategy that is consistent with the objectives and policy guidelines of the
client or institution is the third step in the investment management process. Portfolio strategies
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can be classified as either active strategies or passive strategies. Essential to all active
strategies is specification of expectations about the factors that influence the performance of an
asset class. In the case of active equity strategies, this may include forecasts of future earnings,
dividends, or price/earnings ratios. In the case of active bond management, this may involve
forecasts of future interest rates, future interest-rate volatility, or future yield spreads. Active
portfolio strategies involving foreign securities will require forecasts of future exchange rates.
b. Those portfolio managers who follow an indexing strategy are said to be “index huggers.”
Why?
An “index hugger” refers to a managed mutual fund that tends to perform much like
a benchmark index. Thus, any portfolio managing using an index strategy can be called an index
hugger. The majority of actively managed funds are expected to outperform the so-called
5. Explain whether you agree or disagree with the following statement: “All duration–
matching strategies are indexing strategies.”
One would disagree with the above statement because a portfolio manager following an indexing
strategy can be ordered not to deviate from the benchmark’s duration. Thus, the manager could
not achieve a desired duration match. For example, even when minor mismatches in the primary
6. The investment objective of the Thread needle bond fund is “To outperform the
benchmark by 3% per annum (gross of fees) over an 18-24 month period” What type of fund
is this?
7. Answer the below questions.
(a) What is meant by systematic risk factors?
Risk factors affecting an index can be classified into two types: systematic risk factors and
(b) What is the difference between term structure and non-term structure risk factors?
Systematic risk factors can be divided into two categories: term structure risk factors and
non-term structure risk factors. Term structure risk factors are risks associated with changes in
the shape of the term structure (level and shape changes). Non-term structure risk factors include
8. The following is reproduced from the Prospectus of the T. Rowe Price Institutional Core
Plus Fund dated October 1, 2010:
“Principal Investment Strategies: The fund intends to invest at least 65% of its net assets in
a “core” portfolio of investment-grade, U.S. dollar-denominated fixed income securities which